Evaristo Corporation is considering an investment in equipment for $45,000. Data related to the investment are as follows: Cash Flow before
Year Depreciation and Taxes
1 $30,000
2 30,000
3 30,000
4 30,000
5 30,000
Cost of capital is 18 percent.
Evaristo uses the straight-line method of depreciation with no mid-year convention. In addition, its tax rate is 40 percent, and the life of the equipment is five years with no salvage value.
What is the payback period in years approximated to two decimal points?

Question

Quizplus · Accepted Answer

The payback period is calculated by dividing the initial investment by the annual cash flow. Here, $45,000 / $30,000 = 1.5 years. However, since the cash flows are before taxes and depreciation, we need to consider the tax shield from depreciation. The annual depreciation is $9,000 ($45,000/5). The tax shield is $3,600 ($9,000 * 40%). The after-tax cash flow is $30,000 - ($30,000 - $9,000) * 0.4 = $21,600. The payback period is $45,000 / $21,600 = 2.08 years.

Evaristo Corporation Is Considering an Investment in Equipment for $45,000